Certain techniques for tracking and trading in volatility are known. For example, in equities, trading in volatility has been done through covered call strategies where investors write call options on stocks they own. In fixed income markets, it is known to sell volatility by investing in the U.S. mortgage market. Because U.S. residential mortgages give the borrower the right to prepay the loan without penalty, investors in mortgage backed securities have return profiles similar to portfolios that are long high quality bonds and short interest rate call options.
However, these and other prior art strategies for trading volatility are hampered by the lack of any clear benchmark for evaluating performance. Indeed, when analyzing the performance of volatility strategies, most analysts tend to track changes in implied volatility, delivered volatility, or the difference between implied and delivered volatility as indicators of the success or failure of option-based strategies. However, these measures fail to capture the extreme nonlinearity of option returns and can therefore provide a misleading picture of the risk-return tradeoff in option-based strategies.
An example of a prior art technique is the Chicago Board Options Exchange's Volatility Index, known as VIX. VIX has several shortcomings. For example, it is computed using implied volatilities of certain S&P 500 options only, it is inaccurate in the short term, and it must be actively managed using subjective judgments; that is, its managers are required to take bearish or bullish views on the portfolio. Another problem with VIX is that an investor cannot use it to determine how much money he or she made in investing in volatility. For example, an investor investing in volatility in January when VIX is at 110 does not know whether he or she made money in February when VIX is at 120, let alone how much money. Furthermore, VIX is based on implied volatility, and therefore does not reflect actual profits or losses that arise from actual volatility trading strategies. That is, VIX is not directly related to the profit or loss of trading strategies that involve real options. Because VIX is based only on implied volatility, it fails to take into account gains or losses from the gamma (γ) effect of delivered volatility (the volatility of the underlying asset itself), and the theta (θ) effect of the passage of time.
U.S. Published Application No. 2005/0102214 to Speth et al. (“Speth”), Ser. No. 10/959,528 is directed to a volatility index and associated derivative contract. However, Speth computes its index as a weighted average of out-of-the-money options. Further, Speth does not employ any options pricing model. The Speth index only uses implied volatility and fails to take into account other parameters, such as gamma (γ), theta (θ), and particulars of a Δ-hedging strategy. Moreover, Speth does not provide actual profit or loss numbers that arise from trading volatility and cannot be used to benchmark real volatility trading strategies that involve trading actual options.
Successful active subjective management would be one way to improve risk adjusted returns on volatility, if it were possible. However, future realized volatility is not driven by a small set of stable factors in the long term, and hence not predictable in the long term. Thus, active management is generally not a viable means of improving risk adjusted returns.